Wallet encryption uses AES-256-CBC to encrypt only the private keys that are held in a wallet. The keys are encrypted with a master key
which is entirely random. This master key is then encrypted with
AES-256-CBC with a key derived from the passphrase using SHA-512 and
OpenSSL's EVP_BytesToKey and a dynamic number of rounds determined by
the speed of the machine which does the initial encryption (and is
updated based on the speed of a computer which does a subsequent
passphrase change). Although the underlying code supports multiple
encrypted copies of the same master key (and thus multiple passphrases)
the client does not yet have a method to add additional passphrases.

At runtime, the client loads the wallet as it normally would, however
the keystore stores the keys in encrypted form. When the passphrase
is required (to top up keypool or send coins) it will either be queried
by a GUI prompt, or must first be entered with the walletpassphraseRPC command. This will change the wallet to "unlocked" state where the
unencrypted master key is stored in memory (in the case of GUI, only for
long enough to complete the requested operation, in RPC, for as long as
is specified by the second parameter to walletpassphrase). The wallet is
then locked (or can be manually locked using the walletlock RPC command)
and the unencrypted master key is removed from memory.

When the wallet is locked, calls to sendtoaddress, sendfrom, sendmany, and keypoolrefill will return Error -13: "Error: Please enter the wallet passphrase with walletpassphrase first."

When the wallet is unlocked, calls to walletpassphrase will fail.

When a wallet is encrypted, the passphrase is required to top up the
keypool, thus, if the passphrase is rarely entered, it is possible that
keypool might run out. In this case, the default key will be used as the
target for payouts for mining, and calls to getnewaddress and getaccount
address will return an error. In order to prevent such cases, the keypool
is automatically refilled when walletpassphrase is called with a correct
passphrase and when topupkeypool is called (while the wallet is unlocked).
Note that the keypool continues to be topped up on various occasions when
a new key from pool is used and the wallet is unlocked (or unencrypted).

When wallet passphrase enrcyption becomes enabled, any unused keys from the keypool are flushed (marked as used) and new keys protected with encyption are added. For this reason, make a new backup of your wallet so that you will be able to recover the keys from the new key pool should access to your backups be necessary.